No Calm Waters for Real Estate Market

December 17, 2012

Real estate as an investment vehicle may have stabilized somewhat recently, but the hiatus isn’t likely to last long, said speakers at Chicago Booth’s Sixth Annual Real Estate Conference. Even if the economy settles down and stronger growth resumes next year, the turbulence may return in three to four years as interest rates rise to historical norms and a tranche of suspect mortgage loans comes up for refinancing.

At the conference on November 6, Election Day, speakers said uncertainty surrounding the “fiscal cliff” would cast a shadow over investment decision making. The conference was opened by dean Sunil Kumar, who noted that real estate recently has received attention from a number of faculty members.

“There’s a significant amount of concern in the markets about the fiscal cliff” arising from the possibility that failure to resolve the tax and spending issues could push the economy into a recession in 2013, said Randy Mundt, chief investment officer at Principal Real Estate Investors, based in Des Moines, Iowa.

The gradual decline in business investment as a percent of GDP in the last four quarters has impeded economic growth, which has played out most visibly in unemployment. “Unlike apartments, we don’t yet have full market recovery in real estate, in office, industrial, or retail,” Mundt said. “Those sectors are dependent on job growth.” Principal estimates that payroll employment isn’t likely to recover to its reach pre-recession peak until 2015 or later.

What primarily has led the recovery in property values are capital markets forces—money looking for a higher return than the negligible rates on offer from government bonds, he said.

This low-rate environment is “challenging for insurance companies,” said Mark Wilsmann, head of real estate portfolio management for New York–based MetLife. In such an environment, real property continues to be a favored asset class because it offers some protection from inflation, he said.

Opportunistic investors are seeking higher yields, said K. Jay Weaver, managing principal at Walton Street Capital in Chicago. But it’s not necessarily easy to find the right investments. “There are a lot more managers raising funds than there are places to invest,” he said.

As a result, it is difficult to get into the real-estate fund management business today, said Alok Gaur, managing director at The Carlyle Group in Washington, DC. A widespread sorting out of fund managers is already happening, he said, not just because of poor returns but because many fund managers didn’t communicate those bad results when they should have.

In the single-family sphere, prices nationwide have declined to the 2003 level, representing “a lost decade” and a “significant drag on the economy,” said Joseph L. Pagliari, clinical professor of real estate and an organizer of the conference. An under recognized effect of this trough in housing has been depressed revenues to state and local taxing authorities, he pointed out. Real estate investors, as part of their due diligence and underwriting, need to look into the fiscal condition of the states and localities where the property is located. For troubled municipalities to balance their challenging budgets, taxes will have to go up, and/or services go down. Neither is positive for tenants and landlords, he said.

The “shadow market” in unsold or under-water homes is going to keep the appreciation bandwagon from rolling again, said keynote speaker Thomas J. Barrack Jr., founder, chairman, and CEO of Colony Capital LLC in Santa Monica, California. Colony’s American Homes unit has been buying defaulted single-family homes and renting them in distressed regions such as Arizona, Florida, and California.

“If you default on the mortgage, you sit in the penalty box for seven years,” he said. “That average renter doesn’t have a down payment, has no sense of what the future is, and no desire to own a home.” These renters don’t want to make commitments, yet they want to raise their children in a single-family house.

There will be another wave of defaults after 2015, when rates go up and balloon mortgages made in 2005 and 2006 come due for rollover, he predicted. For homeowners and investors, therefore, bank lending is not likely to ease up any time soon. — J. Duncan Moore Jr.